In general, a swap is an agreement to trade future cash flows based on the future value of one or more market variables. There are many variations and types of swaps. An equity swap is swap with payments on one or both sides linked to the performance of equities or an equity index. Equity swaps are useful to: (1) initiate and maintain cross-border equity exposures either in an index or a specific stock portfolio; (2) temporarily eliminate exposure to an equity portfolio without disturbing the underlying equity position; and (3) increase, reduce, or eliminate market exposure to a single issue or a narrow stock portfolio or obtain greater diversification for a limited period of time without disturbing an underlying position.
In a simple equity swap, one party contracts to pay the return or depreciation on shares of a financial instrument, such as a stock or a derivative. The block of shares is worth an amount based on the market rate, this is the principal of the equity swap. Since in an equity swap agreement, the parties do not exchange the principal, it is termed a notational principal. In return, the party on the other side of the equity swap agrees to pay a fixed or floating interest on the notational principal.
The first party (the “client”) is generally an entity that desires to realize the gains associated with owning certain equities but either does not have or want to expend money to purchase the equities on the market. The second party (the “financier”) is typically a larger institution having capital to purchase equities but desires to minimize the risk of owning the equities. In an equity swap, the financier is in a sense providing the capital for the client to realize the gains or losses of the equity. Hence, the terms “financier” and “client” are used herein to make clearer the respective positions of the parties.
In an equity-swap sell transaction, the first party agrees to pay the stock's depreciation, while the second party agrees to pay interest on the notational principal at a particular interest rate and also pay to the first party any stock appreciation.
In an equity-swap buy transaction, the first party agrees to pay stock appreciation. In return, the second party agrees to pay interest on the notational principal and stock depreciation.
For example, say that a financial institution owns $100,000 shares of stock X. Through financial forecasting, the financial institution predicts that stock X will appreciate. The financial institution, however, wants to take on as little risk as possible. So to hedge against possible losses, the financial institution enters into an equity swap as follows. First, the financial institution sells the 100,000 shares of stock X at $10.00/share on the open market collecting $1,000,000.00 in cash and invests the $1,000,000.00 at the London Interbank Offered Rate (LIBOR) of interest. At the same time, the financial institution enters into a sell equity swap with a mutual fund in connection with 100,000 shares of stock X. The financial institution agrees to pay the mutual fund: (1) some interest rate less than LIBOR on a $1,000,000.00 notational principal; and (2) depreciation on the 100,000 shares of stock X's market value. In return, the mutual fund agrees to pay: (1) appreciation of stock X; and (2) a flat fee. Thus, the financial institution has hedged its original sale of stock X on the open market to the extent of the interest rate differences and the flat fee. And, if as the financial institution predicted, the stock appreciates, the financial institution will realize a gain greater than if it would have kept the stock and realized the market-rate appreciation. The mutual fund, perhaps predicting depreciation, benefits because it does not have to expend the capital required to transact a short sale on the market. The mutual fund has also hedged itself against appreciation of the stock in the event that it was wrong in its prediction that the stock would depreciate.
Following the facts above, but the financial institution anticipates a fall in stock X's share price, the financial institution could hedge against the risk associated with owning 100,000 shares by entering into a buy equity swap with the mutual fund. In the buy swap, the bank agrees to pay the mutual fund appreciation on the 100,000 shares of stock X. In return, the mutual fund agrees to pay the financial institution: (1) a flat fee; (2) depreciation of stock X; and (3) interest on a notational principal of $1,000,000.00 at the LIBOR rate. If the stock appreciates, the bank is hedged to the extent of the interest rate and the flat fee. On the other hand, if the stock depreciates the bank gains are greater than if it simply sold the stock short on the open market. The mutual fund benefits because it does not have to expend $1,000,000.00 of its own money to purchase 100,000 shares of stock X.
Mutual fund institutions typically have a large number of different funds each comprising financial instruments of varying risks, types, and maturity dates. Thus, the mutual fund managers can offer investors appropriate funds according to the individual investor's risk-management strategy. Accordingly, as the mutual fund enters into equity swap agreements with financial institutions, it must sub-allocate the equity swaps to various funds as appropriate. Typically, the mutual-fund manager provides the financial institution with instructions to sub-allocate the equity swaps among the mutual fund's various fund accounts. For example, these sub-allocation instructions might be in the form of a complicated spreadsheet faxed to the financial institution's appropriate department. Having to provide sub-allocation instructions in such a manner restricts control and flexibility of the fund manager. In order for the fund manager to make complicated sub-allocations, he must transmit increasingly complicated instructions. It follows that the greater the number of equity swaps, the less control and flexibility the fund manager has over sub-allocation. An even more tedious variation is that the fund manager sub-allocates by manually entering data into an in-house allocation platform. One can imagine the difficulty of instructing a financial institution to sub-allocate a 100 equity swaps per day to various funds according to percentages, dates, prices, number of shares, etc.
What are needed are network-based sub-allocation methods and systems that permit parties to an equity swap a high degree of flexibility and control to sub-allocate a large number of equity swaps into various accounts.